Now that the financial reform debate is heating up again, I want to caution people against viewing a wider clearing requirement for OTC derivatives as necessarily better. Clearinghouses are not a panacea by any means, and pushing instruments that aren't mature enough or sufficiently liquid for clearing onto clearinghouses would be a very bad idea.

In order to properly manage counterparty risk, a clearinghouse needs to be able to accurately price the instruments it clears. Clearinghouses manage counterparty exposure by requiring counterparties to post initial margin at the beginning of the trade, and — crucially — daily variation margin. As explained by Robert Bliss and Robert Steigerwald in a Chicago Fed paper:

Margining systems are designed to ensure that in the event that a clearing member fails to meet a margin call, sufficient funds remain readily available to close out the member’s positions without loss to the CCP in most market conditions. As a complementary risk-management mechanism, the gains and losses from open positions are posted to a clearing member’s margin account on a regular (usually daily) basis and result in calls for variation settlement (or variation margin). The variation settlement reflects periodic mark-to-market fluctuations and is an important mechanism for assuring the collateral held by the CCP is likely to be sufficient to meet the needs of the CCP in the event of a default.

Given the extent to which clearinghouses rely on market prices to mitigate counterparty risk (which is, after all, the main reason we're pushing central clearing in the OTC derivatives space), it's absolutely crucial that the mark-to-market prices be reasonably accurate. Reliable mark-to-market pricing, of course, requires a liquid market.

It seems that a lot of people are pushing for the government to "err on the safe side" by enacting a very wide clearing requirement for OTC derivatives, with exceptions only for truly bespoke deals. The more OTC derivatives that trade through clearinghouses, the safer the system, right? Well, not really — it's not at all clear that this approach would be "erring on the safe side."

In fact, we have a very good example of the potential dangers of this approach: AIGFP. Yes, I'm fully aware that AIG's CDSs weren't centrally cleared. But they were fully collateralized, requiring AIG to post collateral daily based on market prices — the equivalent of a clearinghouse collecting daily variation margin from counterparties to cleared trades.

Most people agree that it was the decision to collateralize their CDSs that ultimately doomed AIG. Since the contracts required AIG to post collateral based on the mark-to-market prices of the underlying CDOs, the decision to collateralize the trades meant that AIG was exposed to short-term fluctuations in the CDO market. AIG was fine with that, because they foolishly believed that the CDO market was deep enough and liquid enough that mark-to-market prices would remain stable.

As everyone knows by now, liquidity in the CDO market vanished, and the market prices of CDOs plunged. Because they had agreed to collateralize their CDSs, AIG was suddenly forced to post billions of dollars in collateral. The effect would've been the same had AIG been required to clear its CDSs through a clearinghouse. The clearinghouse would've required AIG to post daily variation margin based on market prices — this, again, is the primary way that clearinghouses mitigate counterparty risk — which means that AIG would've been forced to post the same amount of collateral when liquidity dried up in the CDO market.

The point is that forcing OTC derivatives that aren't sufficiently liquid onto clearinghouses is not necessarily "playing it safe" from a regulatory perspective. It greatly increases the chances that a clearinghouse will misprice its counterparty risk, and end up not having collected enough variation margin to cover the losses from a default. And I, for one, would rather not see what a clearinghouse failure looks like in my lifetime.

241
comments:

I've been thinking about this issue quite a bit, and I think I agree with your position. Exchanges aren't magic -- whatever they do for margin must be conservative if they want to survive. But that runs against the interests of speculators that don't want to have much capital trapped inside margin requirements.

To truly remain safe, with a clearinghouse where all the trades are with the clearinghouse, a participant would have to post some sizable fraction the "worst" result that he might have to pay on. I think of 50% on stocks, and say that if we size the risks off of that, we are probably okay, though I have heard rumors (Yves Smith's book, P. 299) that the NYSE and CME almost failed in 1987. So maybe we would need something more, but if we applied a higher standard, maybe few would want to use the clearinghouses.

My view is try to do interest rate swaps in a clearinghouse -- if that works, expand it. Gotta walk before you can run.

Your point is valid in that excess exposure causes systemic risk. One way around this that clearinghouses have adopted is imposing position limits to reduce the chance that any one participant brings down the clearinghouse. If AIG had had a cap on its CDO positions in a clearinghouse,the clearinghouse would have had early warning, and could have required collateral early. Now position limit exemptions do exist, but if they're properly managed, clearinghouses do have a braking mechanism.

I completely see the logic of your point, but AIG's position wouldn't be exogenous to being on a clearinghouse; ideally, as anon@5:33am mentions, they would have had some breaks applied to them earlier.

If AIGFP position wasn't collateralized, what would have happened? My knee-jerk reaction is the situation would have been far worse. They would have been more aggressive and been further in the hole at the end. But I think you could think through that counterfactual better than me.

No way was the collaterization in any way like what a clearinghouse does.

the margin held against a position is the first line of defense in a clearinghouse. It is the last line of defense in bilateral contracts.

Clearinghouses typically have 3-5 levels of "panic" Not only do they have the collateral - they have the ability to just take more from you. then they have the ability to fall back on their own resources. then they have the ability to take collateral from other clearing members in several stages.

It is the last line of defense - the ability to take collateral from clearing members - that makes clearinghouses much more stable than any bilateral contract.

Why? because the people that are not part of the trade will start to complain when positions get too large. They don't want to be on the hook if the trade goes bad and someone cannot pay.

That dynamic is the magic of a clearinghouse. It is a natural oversight that the bilateral market does not have.

Additionally, at any time, you can see anyones position. At any time, systemic regulators can come in and say that an individual firm or group of firms have too much risk on and make them take it off.

This is impossible when JPM is the "clearinghouse"

And maybe the NYSE almost failed, but I doubt the CME was anywhere close.

I agree with Mike Sankowski, that demanding collateral is the last line of defence. But most clearing funds are structured around participant contributions, and squeezing AIG to full collateralization would probably have happened well before any other participant gets called for contributions.

As for spreading the risk across multiple clearinghouses, yes it can happen and given that CDOs aren't standardized contracts, would probably be easier. One way around this is to layer information sharing between houses on nominal asset class positions, but that is unrealistic given the multiple jurisdictions and competitive concerns.

Probably a better approach is to rely on tight position limits across houses, since there aren't THAT many houses. Couple that with mandatory disclosure when a firm wants to increase position limits and you have a more practical, self-limiting solution.

As for clearinghouses increasing the cost of transaction, that seems pretty much a feature and not a bug.

The original point about needing rock-solid, reliable marks still stands of course; and since almost all houses use a margin methodology based on historical volatility, surprises can and do happen.

On the plus side, at least there are now some decent vol numbers to play with... ;)

Sorry if i make any spelling/grammar errors; typing on a mobile isn't that easy.

"And maybe the NYSE almost failed, but I doubt the CME was anywhere close."

The underlying source of this claim is MacKenzie's An Engine, not a Camera, which in turn in based on Leo Melamed's autobiography and interviews with participants. Melamed was chairman of the CME, where S&P futures were traded, in 1987. According to Donald MacKenzie:

At 20 minutes to opening, the Merc was still short $400 million in clearing funds -- and wouldn't be able to open on Tuesday -- which would undoubtedly have added dramatically to the panic set off by Monday's crash. Melamed begged the Merc's banker to guarantee the shortfall, but she said she couldn't do anything -- until the chairman of Continental Illinois walked into her office. The difference was covered at three minutes to opening.

Lind, a former CME chair, had pressured the board to open despite the shortfall: "The Fed just spent all these billions of dollars that you are about to demolish. If we don't open, we may never open again. You will have ruined everything they did. Closing the Merc will not help. If you're broke, you're broke."

Basically (as you can find in documents on the NY Fed's website), Greenspan and the NYFed engineered a bailout of the NYSE and the CME.

There's definitely a huge issue with the pressures on government to bailout bankrupt clearinghouses/exchanges.

EOC: I thought one of the issues was that AIG did not have to be fully collateralized, because of its credit rating. Then, after AIG was downgraded, the lower threshold was triggered and it did have to post full collateral, encountering the liquidity risk you discuss. I may be confusing the sequence of events and triggers here, though. Can you clarify? Thanks.

"Why? because the people that are not part of the trade will start to complain when positions get too large. They don't want to be on the hook if the trade goes bad and someone cannot pay.

That dynamic is the magic of a clearinghouse. It is a natural oversight that the bilateral market does not have."

The question is would this work in a panic, and would there be a natural tendency to let things ride if times are good?

In other words, what level of resources does the Clearinghouse need to keep available? All you've done is transfer the bottom line defense to a common fund of sorts. Does that lead to vigilance or complacency?

Leon43: That is exactly what happened. Some of the AIG swaps were not collateralised at all (people didn't think it was needed - they were so highly rated, afterall..). After the ratings downgrade the counterparties could then demand collateral. (It's no different to the whole CDPC idea. No one has yet convinced me to take on one of them as a counterparty in anything. I doubt they will.)

The stupid thing is, these downgrades occurred because they were allowed to borrow money from a subsidiary. The minute that happened the collateral calls came and I'm sure those calls came in over and above the amount of money they had just borrowed from said subsidiary (just a guess - I can't prove this and not wanting to say anything contentious). Nice work.

The whole really just highlights what a ridiculous situation both AIG and their counterparties got themselves in to. Anyone who previously thought that buying super-senior protection from a monoline (or, frankly, anybody...:-), was a good idea soon realised the flaw in their carefully thought out plan.

Well kids, I'll spare you stories of when I was a boy, and we had defaults twice a day (three times on Sunday) and we liked it that way.

Anyone who is interested can read about Potato and Silver futures way back in the 1970s.

Short version is that yes, you need more than just a clearinghouse. Well designed trading rules that allow the "responsible adults" regulatory power up to and including the ability to limit or even shut down trading in problem markets are needed too.

If a clearing house is merely a method to more efficiently shovel money to the latest joker who has figured out how to manipulate a market, well yes that would be a bad idea.

NETTING is the key issue here. The advantages of a firm netting all its derivatives at one place... the clearing house.... would greatly reduce the chance of being bankrupted by collateral requirements. This is because any sensible derivatives desk would be trying to more or less hedge their exposures, with only a limited principal position. If a derivative can't be easily marked to market, its in the public interest to discourage that trade through the regulatory burdens.

Hi EOC,I am not familiar with exact workings of CDS or CDOs so I could be wrong here, but I am not sure your example of AIG exactly mimicks a clearinghouse. A clearinghouse requires initial margin. I am not sure anybody checked that AIG had enough initial margin for its open positions. I would argue under a clearing house it would have never been able to underwrite so many CDS'sSecondly, AIG was posting collateral but after posting collateral it probably had less initial margin for other position so under a clearing house it would have had to close some of the other positions out.My feeling is that under a clearing house AIG would have never had such large positions and it would have been forced to cuts its size immediatley as some of its positions soured.I would appreciate your feedback.

i will live in a world with hundreds of competing clearinghouses where assets will be netted against other assets with such precision that i will post nearly no margin, because even outside of the fact that competition between clearinghouses will seek this ideal margin level, there will have been years of clearinghouse failures and successes to determine such netting.

Rajat is right about how a clearinghouse would have damped AIGFP activity levels. And while EOC is right that a clearinghouse is not a panacea, he is wrong about collateralization. AIGFP had no collateralization obligation under AIG (parent guarantor) was downgraded; then it had a "cliff" collateralization requirement to post collateral in the full amount of its exposure (which it promptly fell off). If AIGFP had been posting variation margin right along, its positions never could have gotten as big as they did -- because even a small collateral posting requirement is a lot more than zero.

Executive Summary:- Clearing/Margining does not remove risk, but rather transforms credit risk into liquidity risk and/or market risk.- For many companies, credit risk is less volatile and easier to manage than liquidity risk- Credit risk is almost always preferable to market risk

A key point is that forcing clearing/margining does not remove risk, rather it transforms risk. In particular, you are transforming credit risk into liquidity risk (in this case, the risk that a company cannot meet the required margin calls). To the extent that liquidity risk leads to less hedging, you may also transform credit risk into market risk (a terrible outcome, by the way).

Take energy utilities as an example. They commonly use basic derivatives (esp. fixed-float swaps) to hedge their portfolio (which helps keeps rates stable for customers and earnings stable for investors). Most of this is OTC. There are hundreds of counterparties to choose from, making credit risk relatively easy to manage simply through diversification. Some utilities augment diversification with margining, but not all. Those that do so generally margin based on collateral thresholds... meaning margin is only posted beyond certain predefined limits (as opposed to an exchange with margins for the full value of the forward contract plus some additional). In any case, each utility uses margining to the degree that it feels appropriate.

Now let's say you force all these utilities to post margin for 100% of the value of their derivative hedges. In contrast to credit risk, liquidity risk is hard for your average utility to manage via diversification, because the market hubs at which they transact tend to be highly correlated. So a utility that's naturally short (a common position), will find that margins calls across all of its purchases are highly correlated, making it very volatile and relatively difficult to manage liquidity risks. Utilities will be forced to carry literally billions in extra liquidity to meet these potential margin calls or simply decided to hedge less. Note that hedging less exposes customers and rate payers to rate and earnings volatility, respectively

It would be extremely irresponsible for Congress to force more OTC derivatives through centralized counterparties without also taking measures to ensure the stability of those CCPs. The House's bill, passed in December, would increase the proportion of volatile derivatives that are centrally cleared, yet it would effectively prevent the Fed from lending to a clearinghouse in a time of market crisis. Fortunately, the Senate draft would guarantee the stability of CCPs by allowing the Fed to treat clearinghouses as depository institutions for the purposes of discount window lending. If we're going to mandate central clearing, we also must protect clearinghouses with access to Fed liquidity.

For a thorough analysis of the central clearing mandate and the necessity of central bank liquidity, see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1583912

I could tell that we’re on the same interest and obsession. Good to know someone I could share my ideas. Looking forward to know and learn some more from you. I'll be glad to share my own thoughts to you soon. Thank you for sharing such valuable articles.

I agree with you. This post is truly inspiring. I like your post and everything you share with us is current and very informative, I want to bookmark the page so I can return here from you that you have done a fantastic job ...

Your blog is outrageous! I mean, Ive never been so entertained by anything in my life! Your vids are perfect for this. I mean, how did you manage to find something that matches your style of writing so well? Im really happy I started reading this today. Youve got a follower in me for sure!

I recently came across your blog and have been reading along. I thought I would leave my first comment. I think it’s a well informatics written post. Its shows the written quality of writer. Welldone friend keep it up..

Hello Athenrye, i have a question about the recent apr bans. I see the topic about it is closed and all accounts were unbanned but can we now turn on the programs that were causing the bans? In my case my ban was caused by my BitDefender Total Security 2010.

Regardless, patch development is usually way outside my sphere of influence and awareness, so I can't really offer any information as to what's going into an upcoming patch unless I'm looped in well ahead of time. A lot of the time the patches are a complete surprise to me when they come in to be tested. I'd love to offer more information on these sort of things, but most of the time, it's simply not an option.

One of those conditions is that I don't generally repeat answers; similarly, there is an archive of already-answered questions from this thread which is linked in that post. I suppose I have to point out that your question has already been answered, that it is archived for easy look-up, and that constant re-posting of deleted questions is not allowed.

No, GMs just summon monsters manually by using a special command. That lets us summon a specific monster and a specific number of them, or groups of a monster at a time. There's at least 1471 individual monsters in KOL that I know of (I had to test them all to document their stats and drops... that took forever!) and apparently more that the developers have not pushed out just yet.

It seems to be some bugs with quests in game and lot of them has been there for quite a long time. is there some solution on its way or ? As i se it: If quests work and no bugs at them - there might be less koxpers ?

No offence at all with my questions Athenrye - I´m just a player who is intrested in game, and wants right to be right.

Previously, tickets could be opened by one CSR and passed around or reassigned to others, which led to a lot of confusion and some seriously messed up handling errors. For instance, there were even times where I'd be assisting on a restoration case only to have a CSR pick up the ticket and close it with an incorrect 'illegal activity' PFR while I was actively working on it. We had a lot of angry words with the CSRs over some of those cases. With this new system, once a CSR accepts a case, it locks onto his account; it's his and nobody else can take it. If the CSR lets the ticket sit too long without taking action on it (about 6 hours, if I recall correctly), the ticket

There's no reason for the game to need to go offline for bugs to be addressed. Those sort of fixes are made by the developers and applied on patch updates or during maintenance periods, so why take the game down in the meantime? Whether or not the game is active has no effect on the rate at which fixes are produced.

Most of players bought cash on Playspan or other web sites and not all web sites give quick reply like 10 min. Sometimes I am waiting for half an hour and I miss event then I just keep ESN code for next one.

So im just wondering might this be because of the clan grade? If not, what might this be? That is a bit of an odd scenario. Unfortunately, I can't say for certain what might have caused that sort of glitch. There are a few different kinds of bugs troubling clans at the moment, though I'm reluctant to think one of the recent fixes might be to blame for this. I'll bring it up with the tech team and see if I can't find some more information on the matter.

In any case, we are getting more content updates coming in the near future that will bring USKO more in line with its cousins. We've got the new Castle Siege War currently in testing and hopefully to be applied as soon as it's ready for release. Following that we've got the Under the Castle Expansion too. Each version of KOL is different in its own way and I doubt they'll ever all be identical to each other, but honestly, they don't need to be. Though I would like to see some items that JPKO has released in USKO...

I have already been contemplating this issueCheap Guild Wars 2 Gold considerably, and i believe To be sure together with your location. Swaps aren't miracle -- what they carry out pertaining to perimeter has to be old-fashioned when they need to endure. Although in which works resistant to the passions connected with speculators that don't aim forRS Gold significantly funds trapped in margin prerequisites.

we definitely go along with perspective you identified earlier mentioned. there are various studies and also conversation about this topic i have witnessed but your thoughts and opinions and analysis is absolutely extensive.

It is really a pleasant along with beneficial piece of information. Now i'm happy that you simply distributed this specific helpful information around and extremely very happy to observe ones content, I will be a lot to help just like as well as go along with your perspective.

The most significant issues which anyone encounter will be justifying exactly what just one want to do in addition to why it'll disturb the actual standing quo -- if to present opinion or maybe starting the converstaion. It truly assists as soon as reading your current substance insisted on the matter you've pointed out. Fine tunning the theory a person talked about will surely take brand-new opportunities in this field regarding curiosity and delivers will probably result anything constructive. I take pleasure in your efforts connected with taking discover regarding preceding outlined make any difference.

One of the greatest problems that will any individual face will be justifying what exactly one particular need to do in addition to exactly why it's going to break up the actual reputation quo -- whether to present opinion or maybe commencing a converstaion. Advertised . assists while reading through ones materials was adamant on the make any difference you've highlighted. Very good tunning the concept you discussed will truly carry fresh options in this region connected with awareness as well as gives can end result one thing good. When i take pleasure in your efforts involving getting discover connected with over mentioned make any difference.

Glad to read your post. The topic that you discussed above is truely very useful. It is really help for anyone to workout. I like it and i will recommend it to others. Thanks for sharing this type of information. Good luck for the future posts.swarovski crystal bags

Completely a fantastic article. Anyone would a new great job. Many thanks when planning on taking this particular require linked to previously mentioned analyzed topic. We are content that individuals observed versions article along with the information that you speak about on the article in will be amazing. Most of these information they are often convenient for people who. Maintain the very good do the job intending.x men costumes

Death, old age, are words without a meaning, that pass by us like the idle air which we regard not Diablo 3 Gold Sale, It takes strength to do what must be done when the work is unpleasant and uncomfortable Diablo 3 Gold, it takes strength to persist in the face of obstacles, when it would be much easier to simply give up Buy Diablo 3 Gold

Wonderful blog post. That is what I was searching for. I really like your blog and I appericiate your efforts. Your article is very helpful for me and many others to work out. I will definitely come back on your site for more stuff. Good Luck for the future posts.crystal handbags

Hey, just looking around some blogs, seems a pretty nice platform you are using. I'm currently using Wordpress for a few of my sites but looking to change one of them over to a platform similar to yours as a trial run. Anything in particular you would recommend about it? please vote my article Midsummer Day

Thank you for sharing to us.there are many person searching about that now they will find enough resources by your post.I would like to join your blog anyway so please continue sharing with us. Medical NurseHealth Tips

I am truly inspired by this online journal! Extremely clear clarification of issues is given and it is open to every living soul. I have perused your post, truly you have given this extraordinary informative data about it. Agen Bola Terpercaya

Great post! I?m just starting out in community management/marketing media and trying to learn how to do it well - resources like this article are incredibly helpful. As our company is based in the US, it?s all a bit new to us. The example above is something that I worry about as well, how to show your own genuine enthusiasm and share the fact that your product is useful in that case. Also visit our website :IONCASINOSBOBETIBCBETSBOBET CASINO 338A855CROWNISIN4DNEOTANGKAS368MM

Excellent post. I was checking continuously this blog and I am impressed! Extremely useful information specially the last part I care for such info much. I was looking for this certain info for a long time. Thank you and best of luck. sarana303

Your blog is very cool. I am very lucky to be able to come to your weblog agen ibcbet and I will bookmark this web page in order that I could come back another time.Keep up the good work. I have never read more interesting articles than yours before. You make me so easy to understand, agen sbobet and I will contiune to share this site. Thank you very much! Thank you so much for the post you do. I like your post and all you share with us is up to date and quite informative. i would like to bookmark the page ibcbet so i can come here again to read you, as you have done a wonderful job.

whoah this weblog is wonderful i really like studying your posts. Keep up the great paintings! You already know, lots of individuals are searching around for this information, you can help them greatly. judi bola

So im just wondering might this be because of the clan grade? If not, what might this be? That is a bit of an odd scenario. Unfortunately, I can't say for certain what might have caused that sort of glitch. There are a few different kinds of bugs troubling clans at the moment, though I'm reluctant to think one of the recent fixes might be to blame for this. I'll bring it up with the tech team and see if I can't find some more information on the matter. distributor momentmoment slimmerjual glucogenmoment teragenproduk propolis moment

The post is absolutely fantastic! Lots of great information and inspiration, both of which we all need! Also like to admire the time and effort you put into your blog and detailed information you offer! I will bookmark your blog.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

Subscribe - RSS

Subscribe via email

Disclaimer

This site is intended for educational purposes only. The content on this site DOES NOT constitute, nor should it be construed as, specific legal advice. The opinions expressed on this site are the author's personal views, and may not represent the opinions of the author's employer(s), past or present. Your use of this site does not form the basis for an attorney-client relationship. Sending the author an email does not create an attorney-client relationship.

You should seek professional legal counsel authorized to practice law in your jurisdiction before acting on any information contained on this site. I expressly disclaim any and all liability of any kind or nature with respect to any act or omission based wholly or in part in reliance on anything contained on this site.